GDP growth in Australia's major trading partners increased a little over recent quarters,
and is within the range of estimates of potential growth (Graph
1.1). Economic growth picked up in China in mid 2016, supported by accommodative financial
conditions and fiscal policy, following slower growth at the beginning of the year. Growth in
east Asia has been little changed over the past year or so, and growth in New Zealand and India
has been relatively strong. GDP growth in the advanced economies has been at or above potential.
This is expected to continue over the next couple of years, which should reduce excess capacity
further. Potential growth in Australia's major trading partners is estimated to have
declined relative to previous decades, reflecting factors such as population ageing as well as
lower growth in productivity and capital accumulation since the global financial crisis. This
decline is most notable in China, the major advanced economies and the higher-income economies
in east Asia.

Growth in global industrial production and merchandise trade picked up in late 2016, albeit from
relatively low rates. Surveyed business conditions have also increased noticeably since late
2016, and conditions in the global manufacturing sector are now at a three-year high. Consumer
sentiment has risen sharply in some of the major advanced economies, and has been at or above
average levels for a few years.

The increase in oil prices over 2016 has contributed to global inflationary pressures. Headline
inflation has picked up in the major advanced economies, and is now close to the central bank's
target in both the United States and euro area (Graph 1.2).
Core inflation edged higher in the United States over 2016, but remains low in the euro area and
Japan. In emerging market economies, headline inflation was broadly unchanged over 2016 as food
price inflation eased and increases in consumer energy prices were constrained by administrative
controls. Globally, a range of measures of inflation expectations increased in late 2016.
Market-based measures of expected inflation largely reversed their declines over the previous
few years, reflecting the prospect of more expansionary fiscal policy in the United States at a
time of limited spare capacity in the labour market.

China and Asia-Pacific

In China, economic growth picked up in mid 2016, following slower growth at the beginning of the
year, as the authorities conducted expansionary fiscal policy and permitted rapid growth in
financing to meet their annual GDP growth targets. The accompanying rebound in property
construction and continued strength in infrastructure investment boosted conditions in the
manufacturing sector and growth in the output of a range of construction-related materials,
including steel. For the year as a whole, GDP growth moderated a little further (Graph 1.3). Investment growth slowed slightly, while
consumer spending was resilient.

To date, the recent resurgence in residential investment has been concentrated in cities near
the eastern seaboard. A considerable overhang of inventory has persisted in inland cities.
Tightening measures introduced by city-level authorities through 2016 to dampen speculative
activity and keep prices in check (including housing purchase restrictions and reduced
loan-to-value ratios) have placed downward pressure on growth in sales in those cities in recent
months (Graph 1.4). Although residential property prices
have continued to rise, price inflation has generally eased since October, especially in the
cities where tightening measures have been introduced; these cities account for 23 per cent of
floor space sold and 33 per cent of residential investment.

The acceleration in residential investment through 2016 contributed to stronger growth in the
manufacturing sector, including industries that supply inputs to construction. This has helped
support demand for iron ore and coal.

Resource imports (including from Australia) grew strongly, offsetting earlier cuts to Chinese
production of these commodities (Graph 1.5). More recently,
however, resource imports have declined a little. This is consistent with the stabilisation in
Chinese production of coal and iron ore, as earlier restrictions on production have been
loosened and global bulk commodity prices have risen.

Higher commodity prices have also contributed to a steady pick-up in Chinese producer price
inflation in recent months. To date, this is yet to pass through appreciably to CPI inflation,
which remains contained overall. However, some sectors, such as transportation services, that
are exposed to commodity prices via fuel costs have reported slightly higher inflation. To the
extent that continued official efforts to restrict property price growth lead to lower growth in
residential investment and weigh on Chinese demand for construction materials, there may be less
upward pressure on steel production, iron ore prices and coking coal prices in coming quarters.

Chinese fiscal policy and financial conditions remain highly accommodative (Graph 1.6). The fiscal deficit widened through 2016 as
revenue growth slowed sharply, partly due to the replacement of the business tax with a
value-added tax. On average, growth in total social financing (TSF) continued at almost double
the pace of GDP growth over 2016, implying an ongoing rise in China's debt-to-income ratio.
However, TSF growth eased a little in December because net corporate bond issuance contracted
sharply following tighter money market conditions in November and December (see the ‘International and Foreign Exchange
Markets’ chapter). Rapid lending to households (mainly mortgages) has been partly
offset in recent months by falling growth in corporate credit.

Developments in China continue to influence outcomes in other Asian economies, which account for
a significant share (20 per cent, excluding Japan) of Australia's exports. GDP growth has
picked up a little in the high-income east Asian economies recently, consistent with the pick-up
in global trade, as these economies are relatively exposed to trade (Graph 1.7). This follows subdued growth over the previous
couple of years. In particular, business investment growth has declined, although strong
construction investment in Korea and more accommodative monetary and fiscal policies have
provided some offset. Employment growth has also slowed, and consumption has grown only modestly
in more recent quarters. In the middle-income east Asian economies, growth has edged higher over
recent years. Domestic demand remains resilient, despite slowing a little over 2016, and will
continue to be supported by accommodative monetary and fiscal policies.

The New Zealand economy grew at an above-average pace in 2016 (Graph
1.8). Growth has been supported by record high net immigration and accommodative monetary
policy. The policy rate has been reduced by 175 basis points since mid 2015. Employment growth
has been very strong and the unemployment rate is around an eight-year low. Despite this, wage
growth has been subdued because record net immigration has contributed to strong growth in
labour supply. Housing price growth has stabilised following the tightening of tax and
regulatory measures, but remains high. Inflation has increased, but remains low. Non-tradables
inflation has picked up since mid 2015 and rising petrol prices have also contributed to
inflationary pressures recently.

The exchange rate appreciation in 2016 has put downward pressure on the prices of traded items.
The economic consequences of the strong earthquake centred near the South Island in November
appear to be limited, as the most severely affected areas are sparsely populated.

Major Advanced Economies

GDP growth in the major advanced economies has been at or a little above estimates of potential
over recent years, supported by accommodative monetary policies and, more recently, less
contractionary fiscal policies. This has led to a gradual absorption of spare capacity and the
US, Japanese and some euro area economies are now around estimates of full employment (Graph 1.9). With growth in the
major advanced economies expected to be above potential over the period ahead, inflationary
pressures should increase. Policymakers in the United States expect to reach their inflation
goal in 2018. The projected pick-up in Japanese inflation is slower, despite the already-tight
labour market, because inflation expectations and wage growth remain low following the earlier
prolonged period of deflation. The projected pick-up in core euro area inflation is less
pronounced, given the higher degree of spare capacity. Inflation in the euro area and Japan is
expected to remain below their central banks' targets until at least 2018.

Year-ended GDP growth picked up over 2016 in Japan and over the second half of the year in the
United States, while in the euro area it remained above potential and around the rates of recent
quarters. Private consumption has been a key driver of growth in the United States and the euro
area over the past two years, while in Japan it has remained subdued following the consumption
tax increase in early 2014 (Graph 1.10). Household
consumption in the major advanced economies will continue to be supported by low borrowing
costs, recovering housing prices, strong employment growth and above-average consumer
confidence.

Private investment growth in advanced economies has been weak in recent years. There has been a
broad-based slowing in US business investment growth since late 2014, including a sharp fall in
energy sector investment. The rise in oil prices provided some support to energy sector activity
over the second half of 2016, and should continue to do so in the near term. Residential
investment growth also slowed in the United States in 2016. In the euro area, investment remains
well below pre-crisis levels, but has grown modestly since early 2015, driven by machinery and
equipment investment. Japanese residential investment has grown strongly since 2015, reflecting
accommodative monetary policy, internal migration and a pull-forward of activity in anticipation
of the now-delayed consumption tax increase in 2017. Large revisions to Japanese GDP –
particularly to the measurement of research & development and construction
investment – indicate that business investment growth was stronger than previously
thought, especially around 2013 and 2014. Business investment in Japan has been little changed
recently, although the recent yen depreciation should provide some support to investment and net
exports. More broadly, business investment in the major advanced economies could be boosted by
further tightening of labour markets and, if sustained, the recent pick-up in consumer and
business confidence (Graph 1.11).

Fiscal policy in the United States has become less of a drag on economic activity since 2015,
and indications from both the new administration and the Congress are that it is likely to
provide additional support to activity in the period ahead. Fiscal policy has also become less
contractionary in the euro area and Japan.

Labour markets have improved considerably over recent years across the major advanced economies
(Graph 1.12). Employment growth has been robust and
workforce participation has increased modestly, providing some offset, at least temporarily, to
the effects of population ageing on labour supply. Unemployment rates have declined considerably
in the major advanced economies, and are currently around estimates of full employment in the
United States and Japan. While tightening labour markets in these two economies have been
accompanied by moderate growth in some measures of labour compensation, overall nominal wage
growth remains low. However, low productivity growth has resulted in above-average growth in
unit labour costs. The improvement in the euro area labour market has been less pronounced, but
unemployment has still declined to its lowest rate in over seven years.

Headline inflation in the major advanced economies increased noticeably in 2016 as oil prices
rebounded, and is now close to the central bank's target in both the United States and euro
area (Graph 1.13). Core inflation has been more stable. In
the United States, core inflation has edged higher in year-ended terms and is close to the
Federal Reserve's inflation goal. In the euro area, core inflation has remained low for
three years, at or a little below 1 per cent. In Japan, core inflation has fallen to its lowest
rate in three years as the effects of the yen depreciation between mid 2012 and 2015 have faded
and domestic inflationary pressures are yet to emerge.

In the United States and the euro area, short-term measures of inflation expectations have
rebounded, coinciding with movements in oil prices and prospects of higher inflation following
the US election. Longer-term market-based measures of inflation expectations have also picked up
from record lows, although these measures can also reflect financial market developments, such
as changes in risk premia. Economists' longer-term expectations have been relatively steady
and remain close to each central bank's inflation target, suggesting that their expectations
remain relatively well anchored. In Japan, inflation expectations declined in early 2016 and
remain low, at around levels that prevailed shortly before the Bank of Japan started its
quantitative easing and announced its inflation target in 2013.

Commodity Prices

Commodity prices have declined a little since the previous Statement. Large declines in
coal prices from very high levels have been partly offset by significant increases in the prices
of iron ore, oil and base metals (Graph 1.14; Table 1.1). The increases in commodity prices over 2016
have driven Australia's terms of trade higher. As discussed in the ‘Economic Outlook’ chapter, the terms of trade are
expected to be higher over the next couple of years than previously envisaged and are expected
to remain above their recent trough.

The spot price of iron ore has increased noticeably since the previous Statement,
partly due to a pick-up in Chinese steel production and increased demand for high-quality iron
ore in steel production to minimise coking coal inputs, for which prices increased sharply over
2016 (Graph 1.15). The iron
ore spot price has more than doubled since its low in December 2015, but it is expected to
decline gradually as additional low-cost production from Australia and Brazil comes on line.

The spot prices of both hard coking coal and thermal coal have declined sharply since the
previous Statement, from very high levels (Graph
1.16). Coking and thermal coal prices are around 45 per cent and 25 per cent lower than
their mid-November highs because temporary disruptions that affected seaborne coal supply in
late 2016 have been largely resolved and Chinese authorities have loosened some of the
production restrictions that have been in place since April. In both cases, prices are still
significantly higher than they were at the beginning of 2016. Coking coal contracts for the
March quarter settled at US$285 per tonne, an increase of more than 40 per cent from the
December quarter benchmark price. Most of Australia's coal exports are still sold under
contract at prices that currently differ substantially from those in the spot markets. While the
profitability of Australian coal miners has improved, the Bank's liaison suggests that
prices would need to remain elevated for some time to induce any noticeable increase in
Australian production.

Oil prices have increased over the past few months, after OPEC and non-OPEC members agreed to
reduce oil production by around 1.8 million barrels per day for six months, effective from
January (Graph 1.14). Prices are currently around their
highest levels in over a year, but still remain well below their highs of early 2014. The
increases in oil prices since the start of 2016 have started to feed through to higher liquefied
natural gas export prices. The increase in base metals prices over recent months has been broad
based.